Of Scrapes and Scraps …a new tool to balance buyers’ and sellers’ risk in M&A transactions.

Our fourth and final entry in this series of articles addresses knowledge scrapes, what they are, how they differ from materiality scrapes and how they can be best put to use in M&A transactions.

Knowledge Qualifiers

The starting point, when discussing knowledge scrapes, is the knowledge qualifier. A knowledge qualifier is a way to limit the reach of a contractual provision to apply only to what an individual (or group of individuals) “knows”. As with materiality qualifiers, knowledge qualifiers generally benefit the seller in a purchase and sale transaction, whereas the buyer will tend to resist including them.

In the M&A context, knowledge qualifiers arise primarily in the negotiation of representations and warranties, where including a knowledge qualifier allows the seller to limit the scope of a representation or warranty, thus making it easier to proffer. In many cases this can be an effective compromise, giving the buyer the comfort of knowing it has received a key representation or warranty from the seller, while ensuring that it is something the seller is able to confidently give.

Knowledge Scrapes

As with materiality scrapes, knowledge scrapes allow the parties to keep knowledge qualifiers in the agreement for certain purposes, while removing them for others based on the needs and wants of the negotiating parties. And as with materiality scrapes, knowledge scrapes are most commonly applied to indemnification provisions.

For instance, a representation related to litigation might be qualified as follows:

“To the knowledge of the Seller, as of the date of this Agreement, there is no breach or anticipated breach by any other party, of a contract to which the Company is a party.”

This is a common representation to qualify “to the knowledge of the Seller” because there are countless scenarios in which a party to a contract could be in breach unbeknownst to the seller. Nevertheless, the buyer will want to ensure, regardless of the seller’s level of knowledge, that it remains indemnified for any loss that might result from such a breach.

In this way knowledge qualifiers can deliver many of the same benefits as materiality qualifiers. Specifically, they can create greater room for negotiation by allowing the seller to limit its burden with respect to disclosure and satisfaction of closing conditions, while giving the buyer strong language around breach and indemnification. Knowledge qualifiers can also limit post-closing disputes around the always tricky question of who-knew-what-and-when. And, perhaps most importantly, knowledge qualifiers can streamline the negotiation process by limiting the significance to the buyer of what can be such an important (and in some cases necessary) qualifier to the seller.

It is important to note that despite their similarities, knowledge qualifiers operate differently from materiality qualifiers, and this difference affects how the two types of scrapes can and should be used. For instance, materiality scrapes can be used to remove qualifiers for either or both of identifying a breach and quantifying a resulting loss. Knowledge scrapes on the other hand can be used to remove qualifiers for identifying a breach, but cannot logically have any effect on quantification of loss, which makes the knowledge scrape slightly less versatile as a negotiating tool.

On the other hand, knowledge scrapes are not susceptible to many of the criticisms levelled against materiality scrapes. For instance, there is very little risk that a knowledge scrape will lead to a flood of miniscule claims or nickel-and-diming by the buyer, makes the knowledge scrape a less controversial tool overall.

One key point that sets knowledge apart from materiality is that knowledge qualifiers are very often an essential inclusion from the seller’s perspective, not simply a “nice-to-have” or a balancing of risk. Knowledge qualifiers are often included to allow the buyer to make a representation or warranty that is demanded by the buyer, and that the seller is otherwise not only unwilling, but literally unable to give. This added significance to the buyer, can make the knowledge scrape all the more valuable to both parties when reaching a negotiated agreement, as it can limit the negative impact on the buyer of what may be a critical point for the seller.

This article is for informational purposes only and does not constitute legal advice. If you wish to discuss your issue with a lawyer, contact Martin today. 613-747-2459 ext.308, [email protected]